An Account of India’s Attempts to Curb the Black Economy, and Why They Don’t Work

Exactly a year ago, on the evening of 8 November 2016, Prime Minister Narendra Modi announced in a surprise broadcast that beginning midnight, currency notes of Rs 1,000 and Rs 500 denominations were to be pulled from circulation, and would be rendered invalid for any transactions. On 7 November this year, ANHAD, a non-governmental organisation run by the social activist Shabnam Hashmi, and 32 other organisations released a report titled Demonetisation: Exorcising the “Demon.” Over January and February, ANHAD conducted a survey of 3,647 respondents across 21 states and union territories in the country, on the public perceptions of demonetisation, and its aftermath. In addition to the findings of the survey, the report also includes the analyses of several issues that arose out of the policy decision, such as its effectiveness in dealing with the initial goals of eliminating black money, counterfeit currency, and terror financing; the government’s shifting narratives on the motive behind demonetisation; and the impact on people across the country.

In the following extract from the report, the economist Arun Kumar, one of India’s foremost researchers on the black economy, details common misconceptions regarding its functioning. Kumar details why moves such as demonetisation, which target cash alone, fail to curb the black economy. “It is a technical step that does not resolve the political problem,” he writes.

Currently, the black economy is estimated to be 62 percent of GDP [the Gross Domestic Product]. That is, on top of the white economy of Rs 150 lakh crore, there is an extra Rs 93 lakh crore of black income. Thus, the size of the economy is Rs 243 lakh crore. This is much less than the potential size of the economy of Rs 1,050 lakh crore but significantly above the white-economy size declared by the government.

If the current Rs 93 lakh crore of the black incomes were white and not black, the government would have collected about 40 percent of it as additional taxes and would have had Rs 37 lakh crores of taxes. This would have given enough resources for education, health, power and so on. These points to the twin problem due to the black economy, namely, shortage of resources for development and the poor utilisation of what is spent.

Concretely, if we are today spending Rs 100 on sanitation, we could have spent Rs 250 on it. Today, when the Rs 100 is sent to the field it is wasted and eaten away, so that only Rs 15 reaches the ground. Thus, if the black economy was not there, today the benefit would be 17 times more than it is.

Black economy is concentrated in the hands of 3 percent of the population. This is not to say that due to petty corruption some others do not earn small sums of black incomes—but the vast bulk of the Rs 93 lakh crores are in the hands of the top 3 percent, who would be around four crore individuals. As it is these people have high white incomes, and on top of that they hold another 62 percent of GDP as black incomes. Those at the bottom do not have any source of earning black incomes. Thus, the black economy aggravates the inequality in the economy between the top 3 percent and the rest. If we consider that about 40 percent of the individuals in society are around the poverty line, then the gap between the top 3 percent and the bottom 40 percent becomes huge. It can be said that the real [income] inequality comes from black incomes, and not white incomes.

People largely believe that black money is held abroad and needs to be brought back. According to my estimate, only 10 percent of the annual generation of black income goes abroad and the rest stays within the country. Out of the sums going abroad a large part is brought back by businessmen via “round tripping” and invested in their businesses here. Of the amount that is kept abroad, a part is consumed in vacations, children’s education and so on or invested in property, business or luxury products. Thus, what remains in liquid form in financial assets is a small part of what goes abroad. Only this part is available, if at all, to be brought back. Even this cannot usually be traced by the government. The reason is that people do not put the money in their names. There are almost 90 tax havens in the world and money is usually routed through them via shell companies. The process is called “layering.”

So, if the Indian government was to ask the Swiss authorities how much of Arun Kumar’s money is in Swiss banks, the Swiss government will reply saying that Arun Kumar does not have an account here. My money may have gone there in the name of some shell company called “Crocodile” registered in Jersey Island. So, it would be treated as British money. The true beneficiary of these accounts is hard to track since the track is obliterated.

Hence, it is futile to try to get back the black money lying abroad. Success has been achieved only when data are stolen from banks, like in the case of LGT Bank of Liechtenstein, or HSBC bank in Switzerland; or when data is leaked, as in the case of the company Mossack Fonseca of Panama Island. The Indian government has not been pro-active in getting such data to prosecute Indians whose names have surfaced in these cases. It initially refused to take the LGT or the HSBC data even when it was offered free of cost. The data was only acceptedwhen the Supreme Court asked for it.

Another misconception is that the black economy is largely in the informal sectors. India’s economy consists of the formal and the informal sectors. The former is registered with the government agencies while the latter is not. The former uses banks and so on for transactions while the latter is usually in the small and cottage sector, which works largely with cash and not formal banking. The informal sector mostly generates small incomes, which are below the taxable limit. So, whether the incomes are declared or not, they are not black incomes.

Yes, there could be some incomes in the informal sector also which would be taxable but are not declared. These would be black incomes. Examples of such cases could be owners of big dhabas, shops, transporters, financiers and so on. However, most of such establishments would be earning incomes below the taxable limits. Most of the labour in these units would have incomes below the taxable limits.

The problem is that our income taxation begins at a high multiple of the per capita income. On top of that there are many concessions and deductions available to tax payers. So, effectively, income taxation begins at three to four times the per capita income and legitimately, a vast number of people are outside the income tax net. Effectively only 1.4 percent of the population pays income tax. In brief, while the informal sector generates some black incomes, a bulk of its incomes are below the taxable limits hence not black. Most of the black incomes are generated in the formal sector.

Demonetisation is not the first time or the only step that the government has taken to check the growing black economy. In the past 70 years, there have been dozens of committees and Commissions that have gone into various aspects of the black economy. There was the report by Professor Kaldor in 1956, the Santhanam Committee in 1964, the Wanchoo Committee Report in 1970, Dagli Committee Report on Subsidies and Controls in 1978 and so on. There have been parliamentary committees as well—they have made thousands of suggestions and hundreds of them have been implemented.

Demonetisation was carried out in 1978; the voluntary disclosure scheme implemented six times; reduction of tax rates took place, from a high of 97.5 percent in 1971 to the present 30 percent;there was removal of controls, like licensing, MRTP, FERA; reservation for small-scale sector, Phased Manufacturing Programme and Planning are gone and so on. In spite of all these measures, the black economy has grown from 4 percent in 1955 to 62 percent in 2012.

The reason is that the black economy is systematic and systemic—illegality is committed systematically. It is not that a businessman commits under invoicing one day but not the next day, or that the doctor states the correct fee one day but not the next. For illegality to be committed systematically, the state apparatus has to be involved. Thus, a triad is formed between the corrupt businessman, the corrupt politician and the corrupt executive. The executive consists of the bureaucracy, police and the judiciary.

In effect, the matter is political and the black economy can only be tackled if the triad is broken. The political class needs to be made accountable to the public. The businessman and the board of directors of companies have to be made accountable to the shareholders. The executive has to be made accountable to the public they are supposed to serve. Today they act as the masters and not public servants.

The black economy represents the weakness of Indian democracy where various institutions and those running them have been corrupted. So, there is need to strengthen the Right to Information, reform elections, bring about inner party democracy, and so on. These long-term structural reforms are crucial for short-term steps to function. We have wonderful laws but they are hardly implemented. We have environmental laws, building by-laws, industrial laws, labour protection laws, but all of them are breached. We have regulatory agencies such as the CVC, CBI, and the ED, but all of them are ineffective due to the political interference and the rule of money power. The Supreme Court has gone to the extent of calling the CBI a “caged parrot,” implying that it is used as a political tool. This is also the reason that demonetisation does not help control the black economy. It is a technical step that does not resolve the political problem of breaking the triad.

As already pointed out, demonetisation is based on the incorrect premise that people hold large amounts of black cash. Even the public believes that. In the immediate aftermath of demonetisation many TV anchors were gloating that those with large black hoards will now be in trouble. But how many people can hold large sums of black cash? Can one lakh people hold an average of Rs 20 crore? They cannot, because that would be Rs 20 lakh crore, which would be more than Rs 17.5 lakh crore, which was the currency in circulation before demonetisation was announced. If black cash is only Rs 3 lakh crore as is likely, the average holding of black cash with people would be about Rs 75,000 per person—not a huge sum of money. In that case, only a few thousand would have had an average of Rs 20 crore in cash, and the rest would have hardly Rs 50,000 each. The reason these sums are so small is that black money is in circulation and not hoarded under mattresses.

India’s politics of the country has become murkier over time, with more and more scams being unearthed. Crony capitalism has always existed but flourished post 1991 as restraint over businesses has declined. Expenditures on elections have increased manifold due to a variety of reasons, and politicians are in the grip of vested interests. They promise one thing and do the opposite on coming to power. Thus, the public has become cynical and votes for the corrupt, thereby marginalizing the issue of corruption. More and more legislators have criminal records and more and more of them are crorepatis who hardly represent the interest of the common people. Alienation of the public from politics is widespread and there is growing cynicism. In such a situation, its attention can easily be diverted from real issues—which those in power do not solve—to the emotional issues.

This is an extract from Demonetisation: Exorcising the “Demon,” published by ANHAD in November 2017. The extract has been edited and condensed.

Arun Kumar is an economist. He formerly taught at the Centre for Economic Studies and Planning at Jawaharlal Nehru University.